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Wednesday, January 23, 2013

Update on RIMM

This is a long overdue update on RIMM.

Since I wrote my original investment thesis 9 months ago, the stock price has been acting like a roller coaster, falling from $13 all the way down to $6.30 and has since recovered and climbed to $18. I accumulated more shares on the way down. I have also reduced my stake on the way up.

Assessing RIMM now

RIMM's management has done many things right. If you are familiar with Apple's history as depicted in Steve Jobs' biography, you will see what RIMM has done was straight from Jobs' playbook when he brought Apple back from the brink of bankruptcy in 1997. At the time, Apple was 3 months away from insolvency. Jobs cut cost, rationalised the supply-chain and cobbled up a stop-gap product iMac G3 to buy time. RIMM did all these. (Granted that RIMM's stop-gap products are not as intriguing as iMac G3. But they did refresh a couple of their BB7 models.) Because of all these tactical moves, RIMM has been cash flow neural.

Besides, what RIMM has done shows also RIMM has a clear understanding of ecology of the mobile industry. In the mobile space, you do not deal with just the end users. Instead you have this entangled triangular relationship: (1) the carriers, (2) the application developers and (3) the consumers. In order to get one group on board, you need to get the other 2 groups on board. This is a virtuous cycle, but going backwards when you don't have the base. To break this chicken and egg situation, RIMM has literally handed out free cash to court application developers. (If Alec Saunders can really pull it off to artificially build an ecosystem overnight and make BB10 a self-sustainable platform, it is destined to be an important case study at B-schools.) Besides, the restructuring of RIMM's pricing model revealed in their recent conference call is an evidence that RIMM is also buying carriers' support.

However, it's not all blue sky. RIMM has made a single most critical strategic decision that has fundamentally altered the value proposition of its turnaround. I'm not saying RIMM has made the wrong decision. They have no choice. They have selected the lesser of two evils.

What am I referring to?

RIMM has completely given up a pillar of its existing ecosystem. RIMM has given up their proprietary management protocol. Instead, both BB10 and BES10 will use the ActiveSync protocol.

The key issue here is old back-office BES can't manage BB10. Consider this: business users constitute a significant portion of RIMM's market. These existing users are still on BB7 only because their companies are still running the old BES. How to get them to buy BB10 phones? They won't buy the new phones unless their companies upgrade to BES10. But the upgrade cycles of information systems at corporations are notoriously slow. Businesses are inherently risk averse. They won't adapt new systems if the systems are not proven. Consumers will buy phones on an impulse. But it can easily take a company months or even years to evaluate a new system before committing to it. (Quick, is your company still using WinXP?)

So, RIMM has given up the lock-in power of their own franchise. It's not unlikely seeing Intel giving up their x86 architecture or Microsoft giving up their Win32 API. But as I said, RIMM has no choice. This decision to use ActionSync makes BES10 able to manage all other phones on the market. It makes BES10 a better value proposition to sell to CIOs.

If you remove this structural lock-in, for business users, what is left is RIMM's brand,
its customer relationships and its history of delivering valuable
solutions. These are by no means worthless. But without the lock-in,
BB10 will be competing with Android and iPhone on equal footing, on features and prices.

(Well, I think one comforting sign is, there are reports that companies have shown up for BES10 testing and training. The uptake of BES10 can be faster than I foresee.)

On valuation and what to do next

At the current price of $18, the margin of safety has gone. Not only that. RIMM's break-up value has actually deteriorated as expected. The value of its BBM network and BES have both shrunk. Donald Yacktman aptly said RIMM's value was a melting ice cube.

RIMM was a net-net at one point. But it is now a pure turnaround story. Its P/B is back to 1.0. So I don't have the downside protection I once had. However, on the flip side, if BB10 manages to become a sustainable ecosystem, the upside is huge. RIMM can easily get back to $40, $50 or $60. But this is a big "if". I have no confidence in myself to handicap it. I don't have much insights on the odds. And I don't much insights on the bull case valuation. If the PC history is a guide, it's winner takes all.

When I bought RIMM, my investment horizon was 3 years. I didn't expect such a dramatic price movement. I didn't expect the price would go up this quick before RIMM turned a profit. Without the downside protection, the possibility of a break-up and real profit, I now have my eyes on the exit. Weighting up all the factors, the odds and my edge, I will probably sell down my stake gradually. I may hold a smaller stake for a long time as the upside is still too good to ignore. The upside still has a good chance to materialise even though I'm not capable to put a figure on it with confidence.

Lessons learnt

In retrospect, if there is one lesson learnt in investment, it is that I was not aggressive enough when averaging-down. I run an already very concentrated portfolio. And this single stock has been (and still is) the biggest position. I was too concerned about the concentration in one stock. In hindsight, my emotion overtook my rational thinking. When the stock was below $7, the probability of losing money approached zero. This should've been the time to back up my truck to load up. But I didn't. But my averaging-down was too timid. (And this is not the first time I make sure mistake...)

By the way, here another interesting thing I've observed.

There was this analyst covering RIMM who was able to move the market. When he changed his target price, the market followed. At various times, this analyst came up with his target prices by weighting different scenarios by their probabilities. There is absolutely nothing wrong with this. But what I disagree with is that he assigned a high probability to the $0 case.

RIMM is debt free. Management shows they are rational, doing all the sensible things to keep its cash flow neural. It has a book value. It has tangible assets. Every single desk at its Canada HQ can be sold for some cash. Its patents can fetch some money. After all, it has cash in the bank. $0? You are kidding me.

This shows the general bias on the Wall Street. Undoubtedly there is a fair chance RIMM will fail and disappear as a company. But they mix up the collapse of an identifiable business entity with the complete destruction of value. They think that when a company ceases to exist, all the value embedded in it will vanish. They think value can only exists if the business is a going concern in its current form. This is the reason why so much emphasis is placed on the P&L's while balance sheets get very little attention. They ignore the possibilities of what Martin Whitman
called "resource conversions". [Ed: Reading this myself again, I realise I implied the management wouldn't drive the company to the ground if BB10 didn't turn out right. The confidence comes from that we have a major shareholder on the board who would steer towards an orderly liquidation. An orderly liquidation is resource conversion.]

5 comments:

Great writeup. I also purchased RIMM stock when it was cheap, and the downside was protected. This stock is highly volatile, but the stock went down way too much. I wish I had bought more myself, but can't complain with the results.

Again, nice to read a rational analysis. There are FAR too many articles written that are trash and the authors do not understand the company or the industry.

I'm also deciding on my exit strategy here, do I totally get out? Much more risk at this price point, but upside can be huge.

I like the evolution of value investing from doing cig butts to holding on to wonderful companies. Since this is your largest position and quite possibly your best researched position, wouldn't you much rather do away with a big chunk and just sit on the potential upside? Another thing about book value is that it is so notorious especially for investment driven businesses - Chanos said something smart recently, that all high-tech companies, even though they might appear cheap from a value standpoint, have to keep pumping money into progress and promise; that said, what would you say is the sale value of RIMM to let's say Google (if it didn't already have Moto). Also, sitting in India I know that the BB is extremely popular, more than the iPod - and if the BB10 is all that it's cracked up to be, you could reconsider selling on your way up. Wrote too much I think :)

Interesting thoughts, tirath. And thanks for the scuttlebutt on the India market.

In my view, the issue with RIMM is it's not a wonderful company with durable competitive advantages at the moment. I can't be certain its BB10 ecosystem can become self-sustainable. And we are talking about a brand new rebooted ecosystem here.

Safety is always my number one concern. RIMM at the current price is becoming a speculation issue. For a speculative position, it has to be smaller.

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